Download appendix to chapter 1

CHAPTER 1
LIMITS, ALTERNATIVES, AND CHOICES
I.
Definition of Economics
A. The social science that studies how individuals, institutions, and society make
optimal choices under conditions of scarcity.
B. Human wants are unlimited, but the means to satisfy the wants are limited.
II.
The Economic Perspective
A. Scarcity and choice
1. Resources can only be used for one purpose at a time.
2. Scarcity requires that choices be made.
3. The cost of any good, service, or activity is the value of what must be given up to
obtain it. This is known as the opportunity cost.
B. CONSIDER THIS … Free for All?
1. Products provided for “free” to an individual are not free for society because of
the required use of scarce resources to produce them.
2. Companies provide “free” goods as a marketing strategy to promote brand
awareness.
3. Products that are promoted as “free” to the individual may actually be bundled
with another good for which the consumer must pay. Because a purchase is
required to obtain them, these products are not really free to the buyer.
4. Therefore, there is “no free lunch,” a common economic expression.
C. Purposeful Behavior
1. Rational self-interest entails making decisions to achieve maximum utility.
a. Utility is the pleasure or satisfaction obtained from consuming a good or
service.
b. Utility is measured in a unit called “utils.”
2. Different preferences and circumstances (including errors) lead to different
choices.
3. Rational self-interest is not the same as selfishness.
D. Marginal Analysis: Benefits and Costs
1. Most decisions concern a change in current conditions; therefore the
economic perspective is largely focused on marginal analysis.
2. Each option considered weighs the marginal benefit against the marginal cost.
3. Whether the decision is personal or one made by business or government, the
principle is the same.
4. The marginal cost of an action should not exceed its marginal benefits. ***!!
1
5. Opportunity cost is the value of the next best thing forgone.
6. Opportunity costs are always present whenever a decision is made!!!
E. CONSIDER THIS … Fast Food Lines—an Economic Perspective
1. People choose the shortest line to reduce time cost.
2. Lines tend to have equal lengths as people shift from longer to shorter lines in
effort to save time.
3. Lines are chosen based on length without much other information—cost of
obtaining more information is not worth the benefit.
a. Imperfect information may lead to an unexpected wait.
b. Imperfect information may cause some people to leave when they see a long
line.
4. When a customer reaches the counter, other economic decisions are made about
what to order. From an economic perspective, these choices will be made after
the consumer compares the costs and benefits of possible choices.
III.
Theories, Principles, and Models
A. Economists use the scientific method to establish theories, laws, and principles.
1. The scientific method consists of:
a. The observation of facts (real data).
b. The formulations of explanations of cause and effect relationships
(hypotheses) based upon the facts.
c. The testing of the hypotheses.
d. The acceptance, rejection, or modification of the hypotheses.
e. The continued testing with an eye toward determination of a theory, law,
principle, or model.
2. Theories, principles, and models are “purposeful simplifications.”
3. Principles are used to explain and/or predict the behavior of individuals and
institutions.
4. Terminology—Principles, laws, theories, and models are all terms that refer
to generalizations about economic behavior. They are used synonymously in
the text, with custom or convenience governing the choice in each particular
case.
B. Generalizations—Economic principles are expressed as the tendencies of the typical
or average consumer, worker, or business firm.
C. “Other things equal” or ceteris paribus assumption—In order to judge the effect
one variable has upon another it is necessary to hold other contributing factors
constant. Natural scientists can test with much greater precision than can economists.
They have the advantage of controlled laboratory experiment. Economists must test
their theories using the real world as their laboratory.
2
D. Graphical Expression—many economic relationships are quantitative, and are
demonstrated efficiently with graphs. The “key graphs” are the most important.
IV.
Microeconomics and Macroeconomics
A. Microeconomics looks at specific economic units.
1. It is concerned with the individual industry, firm or household and the price of
specific products and resources.
2. It is an examination of sand, rocks, and shells, and not the beach.
B. Macroeconomics examines the economy as a whole.
1. It includes measures of total output, total employment, total income, aggregate
expenditures, and the general price level.
2. It is a general overview examining the beach, not the sand, rocks, and shells.
C. Positive and Normative Economics.
1. Positive economics describes the economy as it actually is, avoiding value
judgments and attempting to establish scientific statements about economic
behavior.
2. Normative economics involves value judgments about what the economy should
be like and the desirability of the policy options available.
3. Most disagreements among economists involve normative, value-based
questions.
V.
Individual’s Economizing Problem
A. Individuals are confronted with the need to make choices because their wants exceed
their means to satisfy them.
B. Limited income – everyone, even the wealthiest, has a finite amount of money to
spend.
C. Unlimited wants – people’s wants are virtually unlimited.
1. Wants include both necessities and luxuries (although many economists don’t
worry about this distinction).
2. Wants change, especially as new products are introduced.
3. Both goods and services satisfy wants.
4. Even the wealthiest have wants that extend beyond their means (e.g. Bill Gates’
charitable efforts).
D. The combination of limited income and unlimited wants force us to choose those
goods and services that will maximize our utility.
E. Budget line
1. Definition: A schedule or curve that shows the various combinations of two
products a consumer can purchase with a specific money income.
2. The model assumes two goods, but the analysis generalizes to all goods available
to consumers.
3. The location of a budget line depends on a consumer’s money income, and the
prices of the two products under analysis.
4. The budget line illustrates a number of important ideas:
3
a. Points on or inside the budget line represent combinations that are possible
given the relevant income and prices. Points outside (up and to the right) the
budget line are unattainable.
b. Tradeoffs and opportunity costs – the negative slope of the budget line
demonstrates that consumers must make tradeoffs in their consumption
decisions; the value of the slope measures precisely the opportunity cost of
one more unit of a good under analysis.
c. Limited income and positive prices force people to choose. Note that the
budget line does not indicate what a consumer will choose, only what they can
choose.
d. Income changes will shift the budget line. Greater income will shift the line
out and to the right, allowing consumers to purchase more of both goods.
Increasing income lessens scarcity, but does not eliminate it.
F. Consider This … Did Gates, Winfrey, and Rodriguez Make Bad Choices?
1. The college decision requires weighing future benefits, including projected
lifetime earnings, against present costs, including explicit costs (tuition) and
implicit costs (forgone wages).
2. Despite the success of celebrities such as Bill Gates, Oprah Winfrey, and Alex
Rodriguez, in general those attending and completing college will earn greater
lifetime earnings (about 50% more) than those holding only high school
diplomas.
3. For Gates, Winfrey, Rodriguez, and others like them, the opportunity cost of
college was extremely high, and it would be hard to argue that they made a
wrong decision.
VI.
Society’s Economizing Problem
A. Scarce resources
1. Economic resources are limited relative to wants.
2. Economic resources are sometimes called factors of production and include all
natural, human, and manufactured resources used to produce goods and services.
B. Resource categories:
1. Land or natural resources (“gifts of nature”).
2. Labor or human resources, which include physical and mental abilities used in
production.
3. Capital or investment goods, which are all manufactured aids to production like
tools, equipment, factories, transportation, etc.
4. Entrepreneurial ability, a special kind of human resource that provides four
important functions:
a. Combines resources needed for production.
b. Makes basic business policy decisions.
c. Innovation of new products, production techniques, and organizational
forms.
d. Bears the risk of time, effort, and funds.
4
VII.
Production possibilities tables and curves are devices used to illustrate and clarify
society’s economizing problem.
A. Assumptions:
1. Economy is employing all available resources (Full employment).
2. Available supply of resources is fixed in quantity and quality at this point in time.
3. Technology is constant during analysis.
4. Economy produces only two types of products.
a. While any two goods or services could be used, the example in the chapter
assumes that one product is a consumer good (pizza), the other a capital good
(industrial robots).
b. Consumer goods satisfy wants immediately; capital goods, which are used
in the production process are important in promoting economic growth.
B. Choices will be necessary because resources and technology are fixed. A production
possibilities table illustrates some of the possible choices (see Table 1.1).
C. A production possibilities curve is a graphical representation of choices.
1. Points on the curve represent maximum possible combinations of robots and
pizza given resources and technology. (Productive Efficiency)
2. Points inside the curve represent underemployment or unemployment.
3. Points outside the curve are unattainable at present.
D. Optimal or best product-mix: (Allocative efficiency)
1. It will be some point on the curve.
2. The exact point depends on society; this is a normative decision.
E. Law of increasing opportunity costs:
1. The amount of other products that must be foregone to obtain more of any
given product is called the opportunity cost.
2. Opportunity costs are measured in real terms rather than money (market prices
are not part of the production possibilities model).
3. The more of a product that is produced the greater is its (marginal)
opportunity cost.
4. The slope of the production possibilities curve becomes steeper, demonstrating
increasing opportunity cost. This makes the curve appear bowed out, concave
from the origin.
5. Economic Rationale:
a. Economic resources are not completely adaptable to alternative uses.
b. To get increasing amounts of pizza, resources not particularly well suited for
the purpose of making pizza must be used. For example, workers that are
accustomed to producing robots on an assembly line may not do well as
kitchen help.
5
F. Optimal allocation revisited:
1. How does society decide its optimal point on the production possibilities curve?
2. Recall that society receives marginal benefits from each additional product
consumed, and as long as the marginal benefit is greater than the additional
cost (marginal cost) of the product, it is advantageous to have the additional
product.
3. Conversely, if the additional (marginal) cost of obtaining an additional
product is more than the additional benefit received, then it is not “worth” it
to society to produce the extra unit.
4. Figure 1.3 reminds us that marginal costs rise as more of a product is produced.
5. Marginal benefits decline as society consumes more and more pizzas. In Figure
1.3 we can see that the optimal amount of pizza is 200,000 units, where marginal
benefit just covers marginal cost.
a. Beyond 200,000 pizzas, the added benefits would be less than the added cost.
b. At less than 200,000, the added benefits will exceed the added costs, so it
makes sense to produce more.
6. Generalization: The optimal production of any item is where its marginal
benefit is equal to its marginal cost. In our example, this must occur at 7,000
robots.
G. Consider This … The Economics of War
1. The costs of the war on terrorism at the end of 2008 were estimated to be around?
{How would you go about making this estimate?}
2. The war on terrorism can be represented by a movement along the production
possibilities curve, as resources are reallocated from “civilian goods” to “defense
goods.” The decision of how much to reallocate should be made by weighing the
marginal benefits against the marginal costs of more defense goods.
3. Marginal benefit – marginal cost analysis is needed to find the optimal mix of
defense and civilian goods. The September 11, 2001, terrorist attacks caused a
perceived increase the MB curve for defense goods, and shifts in resources
toward defense goods since the attacks reflect that perception. As the model
reveals, however, it is possible to go too far, sacrificing too many civilian goods
to obtain defense goods.
VIII.
Unemployment, Growth, and the Future
A. Unemployment occurs when the economy is producing at less than full employment
or inside the curve (point U in Figure 1.4).
B. A growing economy results in larger total output, and is illustrated by an outward
shift of the production possibilities curve.
C. There are three main causes of economic growth.
6
1. Increases in the quantity of resources supplied.
2. Increases or improvements in the quality of resources supplied.
3. Advances in technology employed in the production or distribution process.
D. Present choices and future possibilities
1. Using resources to produce consumer goods and services represents a choice for
present over future consumption.
2. Using resources to invest in technological advance, education, and capital goods
represents a choice for future over present goods.
3. The decision as to how to allocate resources in the present will create more or
less economic growth in the future. (Key Questions 13 and 14)
E. A Qualification: International Trade
1. A nation can avoid the output limits of its domestic production possibilities
through international specialization and trade.
2. Specialization and trade have the same effect as having more and better resources
of improved technology.
IX.
LAST WORD: Pitfalls to Sound Reasoning
A. Biases—Preconceptions that are not based on facts.
B. Loaded terminology.
1. Terms that contain the prejudice and value judgments of others.
2. It is very difficult for a person to describe economic behavior without letting
their options about that behavior creep into their discussion. The distinction
between positive and normative statements is not always clearly apparent.
3. Often, however, there is a deliberate attempt to sway opinion by using loaded
terminology (greedy owners, obscene profits, exploited workers, mindless
bureaucrats, costly regulations, creeping socialism).
C. Fallacy of Composition
1. Fallacy: What is true for one individual or part of a whole is necessarily true for
a group of individuals or the whole.
2. Examples: An individual stockholder’s sales of shares v. a large number of
stockholders selling large numbers of shares; revenues of an individual cattle
rancher v. falling prices due to the actions of a large group of cattle ranchers
D. Causation Fallacies
1. Post hoc fallacy: When two events occur in time sequence, the first event is not
necessarily the cause of the second event.
2. Correlation versus causation: Events may be related without a causal
relationship.
a. The positive relationship between education and income does not tell us
which causes the increase in the other. (Which is the independent variable
and which is the dependent variable?)
b. It may be that the increased income that occurs with increased education is
due to some other third factor that is not under direct consideration.
7
APPENDIX TO CHAPTER 1
I.
Graphs and Their Meaning
A. Graphs help students to visualize and understand economic relationships. Most of
our economic models explain relationships between just two sets of economic facts.
B. Constructing a two-dimensional graph involves drawing a horizontal and a vertical
axis.
1. Mark the axis using convenient increments and fitting the data given.
2. Each point on the graph yields two pieces of information, the quantity of the
variable on the horizontal axis and the corresponding quantity of the variable on
the vertical axis.
C. Direct and inverse relationships
1. If two variables change in the same direction (an increase in one is associated
with an increase in the other) it is a direct or positive relationship.
2. If the two sets of data move in opposite directions, they are inversely or
negatively related.
D. Dependent and independent variables:
1. Economists are often interested in determining which variable is the “cause” and
which the “effect” is when two variables appear to be related.
2. Mathematicians are always consistent in applying the rule that the independent
variable or “cause” is placed on the horizontal axis and the dependent variable or
outcome (effect) is placed on the vertical axis.
3. Economists are less tidy, and traditionally have put price and cost data on the
vertical axis.
4. Note that inverse relationships are downward sloping to the right and direct
relationships are upward sloping to the right regardless of which variable is
placed on the horizontal or vertical axis.
E. Other things equal
1. When economists plot the relationship between two variables, all other
influences are assumed to remain exactly the same (ceteris paribus).
2. If any of the other factors do change, a new plot of the relationship must be
made.
3. This point is extremely important for student understanding of the market model
developed in chapter 3. It provides the distinction between a “slide” along an
existing curve, and the “shift” of a curve that is required if a variable not labeled
on the axis is changed.
8
F. The slope of a straight line is the ratio of the vertical change to horizontal change
between any two points on the line. Some students will remember this as “rise over
run.”
1. The slope of a line will be positive if both variables change in the same direction
(a positive or direct relationship).
2. The slope of a line will be negative if the variables change in the opposite
direction (an inverse or negative relationship).
3. The numerical value of the slope will depend on the way the relevant variables
are measured.
4. Economic analysis is often concerned with marginal changes, the relative
change in one variable with respect to another; it is this rate of change that is
measured by the slope.
5. Lines that are parallel with either the horizontal or vertical axis indicate that
the two variables are unrelated, that is, a change in one variable has no effect
on the value of the other.
a. A vertical line has an infinite slope. It is worth noting that often students
learn in mathematics courses that the slope of a vertical line has an undefined
slope.
b. A horizontal line has a zero slope.
G. The vertical intercept of a line is the point where the line intersects the vertical axis.
H. Equation of a linear relationship
1. If the vertical intercept and the slope are known, the general form y = a + bx
describes the line.
2. y represents the variable on the vertical axis (the dependent variable in standard
mathematical form) a is the vertical intercept, b is the slope of the line, and x
represents the variable on the horizontal axis (the independent variable in
standard mathematical form).
3. The income—consumption example places the dependent and the independent in
proper mathematical form.
4. The price-quantity example reverses their position and places price (the
independent variable) on the vertical axis and quantity (the dependent variable)
on the horizontal axis
I. Slope of a nonlinear curve
1. The slope of a nonlinear relationship changes from one point to another.
2. The slope of a curve at point a is equal to the slope of a line tangent to the curve
at point
9
10